The High Court of Australia delivered a landmark 4–3 decision this week in favor of PepsiCo Inc., dismissing the Commissioner of Taxation’s appeals in the long-running royalties and diverted profits tax dispute with the company.
The case shows that the Australian Taxation Office can’t wish a royalty into being where none exists. It is a win for freedom of contracting and a dead end for the ATO after many years of battle.
The court held a magnifying glass to PepsiCo’s contractual arrangements with Schweppes Australia Pty Ltd., or SAPL, and it couldn’t find a payment for a royalty in them. The contracts meant what they said—the relevant payments were for the purchase of concentrate only.
Where a “comprehensive commercial arrangement” exists between arm’s-length parties, the ruling now makes it much harder for the ATO to argue that “embedded royalties” are in cross-border supply arrangements and to deploy the DPT in similar contexts.
Background
The case arose from payments made under “exclusive bottling agreements” by SAPL to PepsiCo Beverage Singapore Pty Ltd., or PBS, for flavor concentrate used to make Pepsi-branded products in Australia.
The commissioner argued that these payments contained an embedded royalty for the use of PepsiCo and Stokely-Van Camp’s intellectual property, and that royalty withholding tax applied under Section 128B(2B) of the Income Tax Assessment Act 1936. The ATO also assessed DPT on the basis that the arrangements were structured to avoid Australian tax.
At first instance, Justice Mark Moshinsky accepted part of the commissioner’s case, finding that a royalty component was embedded in the concentrate payments and that DPT would apply.
But in June 2024, the Full Federal Court majority (Justices Nye Perram and Ian Jackman) overturned that decision, holding there was no embedded royalty, no derivation by the US entities, and no reasonable alternative postulate for DPT purposes. Justice Craig Colvin dissented on DPT but agreed RWHT didn’t apply.
High Court Decision
The High Court held that on the proper construction of the exclusive bottling agreements, the payments were “for concentrate only,” and that any payment made by SAPL to PBS wasn’t paid or credited to or derived by PepsiCo or Stokely-Van Camp. This meant the statutory conditions for RWHT weren’t satisfied.
The ATO had argued that unless part of the price for the concentrate was a royalty for the use of IP, the use of the IP was obtained by SAPL “for nothing.”
The majority accepted as a matter of fact that the more successful SAPL was, the more valuable the PepsiCo IP became. This dynamic in the commercial bargain wasn’t “nothing,” and accordingly, there was “no legal or economic reason” to make a “leap in logic” that the IP was provided for nothing. The majority concluded that “[t]o do so would involve assigning part of the fair price paid for goods to a different commercial bargain.”
On DPT, the court majority held the commissioner’s proposed counterfactuals, including removing the royalty-free license clauses, weren’t reasonable or commercially realistic. The majority also found that the arrangements didn’t meet the principal purpose test under Section 177J of the Income Tax Assessment Act, with only the US tax-saving factor favoring the commissioner.
Key Observations
Contractual clarity as the decisive factor. The High Court’s reasoning underscores that clear contractual drafting, especially around the nature of consideration, is the first line of defense against recharacterization.
Without an express allocation to IP rights, tax authorities face steep hurdles in asserting an embedded royalty. Here, the exclusive bottling agreements’ unambiguous language that payments were for concentrate only was decisive.
Narrower application of RWHT and DPT. For RWHT, the decision reinforces that the payment must be “derived by” and “paid or credited to” the relevant nonresident before tax can be imposed.
For DPT, the ruling underscores the high hurdle for taxpayers to displace the Commissioner’s counterfactuals. PepsiCo succeeded in showing that no commercially realistic alternative existed, beyond the arrangements actually adopted—an outcome that may be harder to achieve in cases involving related-party dealings and transfer pricing rules.
In noting “critical facts, unique to these appeals,” the court gave weight to PepsiCo’s arrangements having arisen from arm’s-length negotiations and having been in place for decades. Evidencing the commercial genesis and longevity of structures can materially strengthen a taxpayer’s position, particularly against counterfactuals advanced under DPT.
Broader international implications. The judgment likely will influence treaty interpretation and cross-border tax policy in disputes involving bundled payments for goods and IP. For global businesses, commercially grounded and carefully drafted agreements remain the best safeguard against aggressive tax authority positions on embedded royalties.
Last year, Scott Levine, then the US Treasury’s deputy assistant secretary for international tax affairs, wrote to Australia’s Treasury that the ATO’s views on software royalties conflict with the Australia-US tax treaty and OECD model tax convention commentary. He even added that the US Treasury was “very disappointed” with a draft taxation ruling the ATO issued in January 2024.
Shortly after the decision was handed down, the ATO confirmed it will review its draft taxation ruling. The High Court ruling will be welcomed in the US, where Treasury officials are likely to watch closely for any revisions. This is a pivotal moment. The ATO can use the High Court’s guidance to ease tensions with the US Treasury—or risk deepening the rift if it resists the decision’s lessons.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.
Author Information
Shaun Cartoon is a tax partner at Arnold Bloch Leibler with focus on corporate, international, and employment taxes, mergers and acquisitions, corporate restructures, and employee share schemes.
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